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THE NON-EQUITY PARTNER BUBBLE

In May 2009, The American Lawyer reported that Am Law 100 firms had increased the number of non-equity partners threefold since 1999, but the number of equity partners grew by less than one-third. As big law leaders continue to pull up the ladder, what will come from the growing cadre of partners-in-name-only? Other than some short-term money for equity partners, nothing good.

Historically, most two-tier firms employed a simple strategy for non-equity partners: up-or-out. Within a reasonable period of time (for no benign reason, it’s gotten longer), non-equity partners either proved themselves worthy of elevation or moved on. Limited exceptions included specialized niche players who could stay indefinitely.

An article in the February 2012 issue of The American Lawyer, “Crazy Like a Fox,” suggests another option: permanent non-equity partners.

The Economic Case

Authors Edwin B. Reeser and Patrick J. McKenna offer financial justifications for the strategy. First, they say, clients unwilling to pay high hourly rates for first- and second-year associates have an easier time swallowing non-equity partner rates, even though they are much greater.

Sometimes, maybe. But clients are now scrutinizing the match between attorneys and their tasks. Using an unnecessarily expensive non-equity partner to perform associate work is dangerous.

Second, they argue, associate recruitment and training are expensive, with each new associate costing $250,000 to $300,000. As a class, Reeser and McKenna assert, “associates do not make money for the firm until sometime in the end of the third or even the fourth year.”

Maybe. But at current hourly rates and required minimum billables, the payback is probably sooner. (Do the math using an average profit margin of forty percent, which is conservative.) But their larger point is correct: non-equity partners are a source of leverage that for the Am Law 50 has doubled since 1985 — from an average of 1.75 to 3.54.

The Problems

Whatever the debatable short-term economic gain, the long-run cost of expanding the non-equity ranks and making them permanent is far greater.

For starters, such lawyers become second class citizens. They know it. Everyone in the firm knows it. They may be decent, hard-working people. But once they receive the scarlet letter of permanent non-equity status, their morale plummets.

It’s understandable. After all, throughout their lives they succeeded at everything they tried — outstanding college record, good grades at a top law school. They’re intelligent and ambitious, otherwise firms wouldn’t have hired them in the first place. But then, after years of hard work they learn that they won’t reach the next level and never will. Only magical thinking can wish away the demoralizing impact of that message.

Any firm creating a permanent subclass of such attorneys takes an individual problem and makes it an institutional one. For example, if permanent non-equity partners do meaningful and fulfilling work, they’ll deprive younger attorneys of those increasingly scarce opportunities. That expands the morale problem into the senior associate ranks where career satisfaction languishes at historic lows.

Conversely, if the permanent non-equity partners are performing tasks that other attorneys avoid, that creates other difficulties. Reeser and McKenna note that such practitioners sometimes “take on non-billable leadership positions…involving pro bono, diversity, recruiting, training, and professional development.” Unfortunately, there’s no better way to send a message of management’s indifference to such pursuits than by putting the B-team in charge.

Finally, the authors suggest that a non-equity track enables firms to “retain some whiz-bang lawyers who have young children they want to spend more time with or who just want to get off the equity partner treadmill.” Remarkably, no one seems willing to rethink the wisdom of a system that produces that unhappy treadmill in the first place.

The presence of more non-equity partners in big law might simply be a residue of the enormous associate classes hired in earlier years. But for firms using them to create a permanent subclass generating short-term dollars, the strategy makes no long-term sense. Because there’s no metric to capture the downside, big law leaders will ignore it.

But if the trend continues, the non-equity partner bubble will grow and the prevailing big law model will develop another enduring chink in its increasingly fragile armor.

In the second half of the last century, BigLaw developed and then fine tuned its pyramided business model. The name of the game was leverage: put an increasingly large cadre of associates at the base of the pyramid, have them bill scads of hours. Bill associates at a rate of three times their compensation; one-third of that amount would cover overhead and the balance would be profits for the partners, Partners sat at the top of the pyramid and waited for the dumbwaiters to send up piles of cash. The notion that large scale profits would be earned by hourly billing of partners was unheard of at BigLaw. The market for legal services was incredibly elastic, as demand for legal services exceeded supply. The fuel of for the pyramided business model was constant growth. BigLaw knew with certainty that it would grow at the rate of 10% per annum, compounded. Hiring and building law firms’ infrastructure was predicated on that growth rate.

The Great Recession put an end to that business model. Suddenly, supply exceeded demand. For the first time since the Cravath model was created, almost all large law firms began to contract. Clients revolted against the Cravath model and, more importantly, began to refuse to feed firms’ profit machines by refusing to pay for time billed by first and second year associates. It began to look like the associate cadre, the base of the pyramid, was in real danger of collapsing.

As law firm managers began to scramble to meet the challenges of The Great Recession, they met their firms’ need for growth and revenues by aggressively recruiting lateral partners with large client followings. These lateral partners were all highly compensated and in order to meet their salary requirements, less productive partners were shoved aside and moved to lower levels of the pyramid structure. Now, law firm revenues are largely driven by hours billed by service and contract partners. Enormous compensation gaps among ranks of partners began to emerge.

Thus emerged the new pyramid, with three tiers of partners, namely, the most highly compensated equity partners, equity partners earning far less and contract partners.
But the real weakness in the New Pyramid is at its summit. Lateral partners with large books of business do not have institutional loyalty, they are proudly free agents offering their portfolios to the highest bidder. And when those at the top of the New Pyramid hop off to a more attractive New Pyramid, the underlying structure can be in real danger of collapse.

I am curious if you have other terms for “non-equity” partners or, rather, what are other related terms. Do you include in your definition “Of Counsel?”

Also, I am a bit confused in the comment by Mr. Kowalski’s response about elasticity. When the demand for legal services exceed the available supply, isn’t the suggestion that firms could charge large fees and the work would continue to roll in? In that scenario, wouldn’t demand be inelastic? In other words, demand did not change as prices rose; demand just continued upward.

I’m using Am Law’s definition of non-equity partner: “Those who receive more than half their compensation on a fixed basis…Retired partners and of counsel are not counted as partners, nor are payments made to them counted in net operating income.” (The American LawyerMay 2011)

Elasticity of demand was prevalent prior to The Great Recession, but no longer. Diminishing demand since the advent of The Great Recession has resulted in lowering the “legal spend” – the amount spent on legal services. Some law firms are marginally increasing their hourly rates this year, but those modest rate increases are often set off by lowered realization rates, namely the amount actually paid by clients after write downs and write offs.